Musings on World events from the perspective of a Social and an Economic Liberal.

Tuesday, October 06, 2009

Latvia's storm begins to rattle windows across Europe

A few weeks ago a senior Estonian political leader said to me that he believed that the biggest threat to Estonia's security came from Latvia. It was not, he explained, that he had any ill-will towards Estonia's southern neighbour, but their failure to get to grips with the economic crisis could have paralysing consequences for the whole of northern Europe, including Estonia.

Now concerns about Latvia are once again increasing. The emergency financing from the IMF and the EU needs to be rolled over and the government is going through a budget process that is contemplating massive cuts in expenditure, despite the fact that the Latvian economy has already shrunk by nearly 20% year on year. As the respite given by summer tourism now comes to an end, the Latvian government is facing what looks like a moment of truth.

Although both Estonia and Lithuania have enacted generally coherent and organised responses to the economic crisis, Latvia's leaders have descended into a wave of recrimination, as they attempt to settle old scores. Time is running out: the budget must be passed by October 23rd and international commentators are warning that the country must bite the bullet on government expenditure or lose the support that is currently in place.

As I have argued before, I do not see why the Baltic States should continue their slash and burn attempt to gain early entry into the Euro by squeezing living standards so aggressively. To my mind, the domestic debt that is denominated in Euros should be redenominated in local currency and then the currency should be repegged. However the policy makers in all three capitals, Tallinn and Vilnius perhaps even more than Riga, have been determined to stick out the crisis without a currency adjustment. The result has been a sharp adjustment in wage rates and a drastic fall in domestic demand. To be quite fair this has eliminated many of the most serious imbalances and current account deficits have been replaced by surpluses. However Latvia, unlike the other two states, has had to take on the burden of a major banking collapse after they were forced to nationalise Parex Banka, which represented around 20% of the local banking market. The cost of this burden is crushing the life out of the Latvian government budget and with it any chance of a spending stimulus that would be the Keynesian answer to the crisis.

The irony is that the IMF and others now feel able to walk away from Latvia because they judge that the contagion effects will no longer carry the systemic risk that was feared last year. The global recovery makes it more likely that assistance to Latvia will not be forthcoming. In this light even the recent rights issue of Swedbank looks less like prudence and more like preparation.

However a forced devaluation of the Lats and probable sympathetic shock to the Estonian Kroon and Lithuanian Litas could indeed have significant knock-on effects across the Euro zone. Aside from the effective breakdown of ERM II that such a devaluation would bring, it could also be that a sudden spike in the risk premium for states inside the Eurozone may put serious pressure on some member states, notably Ireland and Greece- yet these are still protected by their membership of the single currency. It is the EU member states that are not in the Eurozone that could see more aggressive attacks against their currencies.

Though such commentators as Ambrose Evans-Pritchard see the potential threat that Latvian devaluation might offer to the Euro, it is the non Euro currencies, such as the Swedish and Danish Krone and the Polish Zloty that may end up taking more collateral damage. Nor is Sterling immune. There is still considerable market disquiet over the UK policy of quantitative easing, and the gigantic deficits this involves, and of course there remains political uncertainty- an uncertainty that in the event of a hung Parliament could be more prolonged than investors are now considering likely.

The crisis is gathering, and if the storm finally breaks in the shape of a devaluation of the Lats the consequences could be significant and unexpected damage across the continent. If the Latvians are now going to be cut loose by the IMF and the ECB, we will at least know where to point the finger if Latvia has the same impact as the fall of Lehman Brothers did last year..

Time to fasten your seat belts, it could be a very bumpy ride this autumn.